1. ABA Tax Section Mid-Year Meeting Fiduciary Income Tax
Committee January 25, 2014 Phoenix, Arizona Brian P. Tsu Melinda
Merk Henderson, Caverly, Pum & Charney LLP SunTrust Bank
Private Wealth Management San Diego, California Vienna,
Virginia
2. Agenda Community Property Overview Key non-tax
characteristics Federal income and wealth transfer tax aspects
Potential pitfalls using joint trusts Transmutation
agreements/planning Increased use of Joint Revocable Trusts (JRTs)
in Common Law Property States Common law property basics Typical
design of JRTs for non-community property Federal income and
transfer tax issues and pitfalls Other post-mortem administrative
issues Using Community Property JRTs to convert common law to
community property 2
3. Overview of Community Property - Community Property
Jurisdictions Community property principles apply to property
acquired by spouses while domiciled in certain jurisdictions
Community property also applies to same-sex couples if the state
recognizes the same-sex marriage for state law purposes States
differ as to whether community property applies to registered
domestic partners Currently, community property jurisdictions
include Arizona, California, Idaho, Louisiana, New Mexico, Nevada,
Texas and Washington as well as many foreign countries In addition
to the above jurisdictions, Wisconsin has adopted the Uniform
Marital Property Act, in effect adopting a community property
system unless spouses elect out The IRS has ruled that Wisconsin
marital property is the equivalent of community property for income
tax purposes [Rev. Rul. 87-13] Alaska has also adopted the Uniform
Marital Property Act, except that spouses must elect to treat
property as community property The IRS has not ruled on whether
Alaskas system constitutes community property for federal tax
purposes 3
4. Overview of Community Property Categories of Property In
general, there are two categories of property in a community
property jurisdiction: Community property Separate property In some
community property jurisdictions, such as California, a third
category of property, known as quasi-community property exists
Quasi-community property seeks to treat as community property, for
purposes of disposition at death or at divorce, property acquired
during marriage in a common law jurisdiction prior to the spouses
domicile in a community property jurisdiction Quasi-community
property does not constitute community property for federal tax
purposes 4
5. Overview of Community Property Working Definition What is
separate property? Property (1) owned by a spouse before marriage,
(2) any property acquired by gift, inheritance or bequest after
marriage, and (3) property converted from community property by
valid agreement What is community property? All other property
acquired by spouses during their marriage while domiciled in a
community property jurisdiction Note: Community property
jurisdictions presume that property acquired by spouses is
community property unless shown otherwise. The IRS acknowledges
this presumption as well [IRS Publication 555] 5
6. Overview of Community Property Key Characteristics
Ownership: Each spouse owns one-half of community property
Management: Each spouse has equal management rights over community
property Each spouse can dispose of only one-half of the community
property at death Also, in general, unless a transferring spouse
has the consent of the other spouse, a spouse may only give away
one-half of the community property during life Title: Title to
community property is generally irrelevant to the interests of each
spouse However, where the character of property is unclear, title
may give rise to presumptions regarding the character of the
property 6
7. Tax Aspects of Community Property Federal Income Tax
Inclusion: One-half of community income is included in the gross
income of each spouse [Lucas v. Earl, 281 U.S. 111 (1930); Rev.
Rul. 55- 726] Basis: At the death of either spouse, each spouses
one-half interest in community property receives a basis adjustment
equal to fair market value. [IRC Section 1014(b)(6)] Note that
quasi-community property does not receive basis adjustment Grantor
trusts: For grantor trust purposes, a grantor includes any
personwho directly or indirectly makes a gratuitous transfer of
property to a trust [Treas. Reg. 1.671-2(e)(1)] Accordingly, upon
transferring community property to a trust, each spouse is treated
as a grantor of that trust 7
8. Tax Aspects of Community Property Federal Wealth Transfer
Tax Community property equalizes estates between spouses as each
owns one-half of such property Inclusion: Upon the death of a
spouse only one-half of the value of community property is included
in the gross estate under section 2033 Gifting: Accordingly, each
spouse is also considered a donor of community property for gift
tax purposes Split gifts: Because each spouse is considered a donor
for gift tax purposes, gifts of community property are
automatically split for gift tax purposes [Instructions to Form
709] 8
9. Tax Aspects of Community Property Federal Wealth Transfer
Tax Fractional discounts: A discount may be available for transfers
of non-marketable community property. [See Propstra v. U.S., 680
F.2d 1248 (9th Cir. 1982)] The IRS has argued unsuccessfully that
such property should be valued at 100% of fair market value less
costs of partition. [See Estate of Cervin v. Commr, 68 T.C. Memo
1994-550] GST tax: The foregoing aspects of community property also
apply to the generation-skipping transfer tax. They apply for
purposes of determining: the transferor under section 2652(a); and
the value of property transferred as such value is determined for
gift or estate taxes 9
10. Community Property Pitfalls Preservation of Community
Property in JRTs As a general rule, transferring property to a
revocable trust does not change the character of the transferred
property That said, the revocable trust should provide, as to any
community property: Property transferred to the trust shall retain
its character as community property As long as both spouses are
alive, they may at any time alter, amend or revoke the trust in
whole or in part, provided that any part of the trust estate so
withdrawn shall be transferred to them as community property Net
income from the trust is community property, and is to be paid to
or applied for the benefit of the grantors [Rev. Rul. 66- 283]
10
11. Community Property Pitfalls Joint Irrevocable Trusts While
many of the planning considerations present in planning for a gift
of common law or separate property to an irrevocable trust overlap,
the creation of an irrevocable trust that holds community property
raises additional traps for the unwary Many pitfalls arise from the
fact that each spouse is considered a donor/grantor as to gifts of
community property for wealth transfer and income tax purposes
11
12. Community Property Pitfalls Incomplete Gifts In many
community property jurisdictions, the non- transferring spouse must
consent a transfer of community property If that consent is not
provided, the gift may be incomplete under Treas. Reg. 25.2511-2(b)
as the donor has not ceded dominion and control Because it is
sometimes possible for a spouse to have acquired a community
property interest in separate property, it may be prudent to obtain
the written consent of the spouse even when making a gift of
separate property 12
13. Community Property Pitfalls Retained Interests under IRC
2036 and 2038 Because each spouse is treated as a donor of
community property, take care to ensure that the terms of the
irrevocable trust holding such property do not create retained
interests Spousal beneficial interests: Beware of gifts of
community property to an irrevocable trust in which a spouse is a
beneficiary if the intention is to exclude the trust assets from
the gross estate of that spouse (for example ILITs and SLATs)
Beware of community property funds used to fund premiums especially
if the state is an inception from title state Fund such trusts with
separate property Even if trust is funded with separate property,
beware of states (for example Texas) where income from separate
property is community property [But See Rev. Rul. 81-221 based on
Federal Fifth Circuits conclusion re: Texas law] Spouse as trustee:
Beware of gifts of community property to an irrevocable trust in
which a spouse has control over a beneficial interest (for example
as a trustee) Limit trustee discretion to ascertainable standard
Fund trust with separate property 13
14. Community Property Pitfalls Qualified Personal Residence
Trusts The success of a QPRT as a wealth transfer vehicle success
depends on the grantor surviving the term of the trust If a
residence owned as community property is transferred to a QPRT,
both spouses must outlive the term for the trust to succeed
Alternatives to joint QPRTs The residence is commonly transmuted to
create one-half separate property interests with the spouses
creating separate QPRTs so that should one spouse predecease the
term, the other trust may still succeed if the other spouse
survives the term Separate QPRTs also allows for other benefits,
not unfamiliar to practitioners in common law jurisdictions,
including different terms tailored to the ages of each spouse and
the availability of a fractional discount 14
15. Community Property Pitfalls Sales to Intentionally
Defective Grantor Trusts Typically, a sale is structured so that an
individual is selling property to a wholly-owned trust under the
grantor trust rules to avoid gain or loss on the sale [Rev. Rul.
85-13] If the grantor trust is seeded with community property, each
of the spouses is a grantor of the trust However, as both of the
grantors are spouses, gain on the sale to the trust is probably
avoided under section 1041 Upon the death of the first spouse, a
portion of the trust ceases to be a grantor trust [Rev. Rul.
75-267] As a result, complexities related to a partial grantor and
partial non- grantor trust may arise as to the: income tax
treatment of the payments on the note questions regarding gain
recognition income tax reporting for the purchasing trust (part
IDGT and part taxable trust) Similar issues may also arise upon the
death of the first spouse as to joint ILITs 15
16. Community Property Pitfalls Grantor Trusts Issues under IRC
674(c) and 675(3) Related or subordinate party status is relevant
to powers possessed by independent trustees to distribute income or
principal to certain classes of beneficiaries under IRC Section
674(c), and with respect to a grantor's borrowing of trust funds
from the trust under IRC Section 675(3) In-laws may often be
selected as independent trustees. If a trust is funded with
community property, an in-law may be a related or subordinate party
with respect to the other spouse 16
17. Overview of Transmutation Agreements - Planning
Opportunities Consider transmuting appreciating separate property
into community property to obtain a basis step-up equal to 100% of
the fair market value of the property Conversely, consider
transmuting depreciating community property into separate property
to limit the basis step-down to 50% of the value of the property
Transmuting community property into separate property to create
separate trusts for the purpose of: avoiding retained interests
where a spouse has a beneficial interest or a problematic power
Increasing the likelihood of success and customizing the terms of
each QPRT to each spouse avoiding the problems associated with a
partial grantor trust in the context of a sale to IDGT 17
18. Overview of Transmutation Agreements - Pitfalls
Transmutation have consequences far beyond income or wealth
transfer taxation Inherent conflict between spouses Some states
have a presumption of undue influence Potential for claim against
attorney upon spouses divorce 18
19. Overview of Transmutation Agreements - Best Practices
Inform spouses of potential conflict Consider separate
representation Put agreement in writing, specifically interests
being transmuted But see Einim, T.C. Memo 1984-130 Transmutation
must be permitted under state law [See Rev. Rul. 77-359] Both
spouses are informed of the assets and liabilities of the other
spouse Both spouses are given sufficient time to consider the
agreement Consult family law counsel 19
20. Common Law Property Basics In non-community property
states, only 50% of any joint spousal property (JSP) is included in
deceased spouses estate [IRC Section 2040(b)] Results in 50% (vs.
100%) stepped-up basis for JSP at the first spouses death Tracing
rules apply if surviving spouse is a non-US citizen 100% stepped-up
basis may be available for JSP created prior to 1977 under the
so-called Gallenstein rule Traditionally, separate revocable trusts
are created by each spouse and funded with the couples separate
and/or JSP Often requires the severance of joint ownership/tenancy
by entirety (TBE) protection to sufficiently fund bypass trust at
first spouses death Some states (VA, MD, Missouri, Indiana,
Illinois Hawaii and DE) preserve TBE character Deceased spouses 50%
interest in any JSP can also be disclaimed by surviving spouse into
bypass trust via qualified disclaimer 20
21. Increased Use of JRTs in Common Law Property States Tax law
changes made permanent under the American Taxpayer Relief Act of
2012 (ATRA) have eliminated or lessened the need to plan for the
Federal estate and gift tax for many married couples Increased
Federal estate/gift tax exemption ($5.34MM for 2014) Portability
election allows for transfer of deceased spouses Federal
estate/gift tax exemption amount to surviving spouse Not available
for GST tax or state estate tax purposes In order to make the
election, Federal estate tax return must be filed at the first
spouses death JRTs are viewed as simpler estate planning solution
One trust document vs. two separate trusts for each spouse
Alleviates need to divide couples joint and/or separate property
between two separate trusts Community property JRT (formed in AL
and TN) may allow couple domiciled in common law property state to
obtain 100% stepped-up basis at first spouses death 21
22. JRTs Typical Design (Non-Community Property) Scenario #1
Estate Equalization JRT Each spouse owns or is deemed to own (via
deemed gifts upon contribution of any separate property to the
trust) an undivided 50% of the trust assets No separate shares are
maintained Both spouses are co-trustees During their joint
lifetime, spouses retain joint right to income and principal, and
joint right to amend and revoke Upon revocation, trust assets are
distributed 50/50 to each spouse May also provide for automatic
revocation and 50/50 distribution upon divorce, unless decree of
divorce directs or the spouses mutually agree otherwise Upon first
spouses death, deceased spouses 50% share is directed to bypass
trust (or to the surviving spouses share, with ability to disclaim
into bypass trust) Surviving spouse retains right to income and
principal, and right to amend/revoke, over surviving spouses share
22
23. JRTs Typical Design (Non-Community Property) Scenario #2
Separate Share JRT Separate shares are created and maintained for
joint property contributed to the trust, and for any separate
property contributed by each respective spouse Both spouses are
co-trustees Spouses retain joint right to income and principal with
regard to the joint property share, and unilateral right to income
and principal with regard to their respective share of separate
property Spouses retain joint right to amend and revoke with regard
to the joint property share, and unilateral right to amend and
revoke with regard to their respective share of separate property
Can be cumbersome to revoke/unwind upon divorce if separate shares
are not maintained Upon first spouses death, deceased spouses 50%
share of joint property, and of all of his or her separate
property, is directed to bypass trust (or to the surviving spouses
share, with ability to disclaim into bypass trust) Surviving spouse
retains right to income and principal, and right to amend/revoke,
over surviving spouses share 23
24. JRTs Typical Design (Non-Community Property) Scenario #3
General Power of Appointment JRT Equalization or Separate Share
plan designs are utilized during the spouses joint lifetime Upon
the first spouses death, the deceased spouse has a testamentary
general power of appointment over part or all of the trust assets
In default of such exercise, the deceased spouses remaining estate
tax exemption amount is directed to bypass trust, any excess is
directed to surviving spouses share Surviving spouse retains right
to income and principal, and right to amend/revoke, over surviving
spouses share Goal is to obtain maximum funding of bypass trust and
100% stepped-up basis at first spouses death Can also be utilized
using separate revocable trusts 24
25. JRTs - Federal Gift Tax Issues (Non-Community Property)
Potential gift to non-donor spouse upon contribution of unequal
amounts of any separate property to JRT Donor spouses right to
revoke does not make gift incomplete if only exercisable jointly
with, or only with the consent of, a person who has a substantial
adverse interest (i.e., non- donor spouse) Even if unilateral right
to revoke over separate property is retained (Scenario #2), may be
difficult to exercise if separate shares are not maintained Gift
would a terminable interest (i.e., life estate) that may not
qualify for the unlimited gift tax marital deduction under IRC
Section 2523(e) or 2523(f) Should qualify as life estate with power
of appointment under IRC Section 2523(e), if non-donor spouse has
unilateral right to revoke (or power to appoint in favor of his or
her estate) over gifted portion Would not be considered qualifying
income interest eligible for QTIP treatment under IRC Section
2523(f), if trust principal from gifted portion can be distributed
to the donor spouse (i.e., any person other than the donee spouse)
Potential gift by surviving spouse to remainder beneficiaries when
bypass trust portion of JRT becomes irrevocable at first spouses
death Any such gift can be rendered incomplete if surviving spouse
retains a testamentary special power of appointment over the bypass
trust 25
26. JRTs Federal Estate Tax Issues (Non-Community Property) May
be unclear what portion of JRT is includible in deceased spouses
estate Affects what portion of the trust assets would be eligible
for stepped-up basis at first spouses death Qualified joint
interest treatment under IRC Section 2040(b) only applies to
property held by spouses as TBE or JTWRS To the extent spouse
contributed property to the trust and retained a right to alter,
amend, revoke, or terminate such interest (either alone or in
conjunction with any other person), property would be includible in
his or her estate under IRC Section 2038 To the extent spouse has
general power of appointment over part or all of the trust assets,
trust assets would be includible in his or her estate under IRC
Section 2041 IRS says no stepped-up basis for portion of trust
assets contributed by the surviving spouse, under IRC Section
1014(e) [PLRs 200101021 and 200210051] Tracing may be required to
determine character/ownership of trust assets, if separate shares
are not maintained Potential inclusion of bypass trust assets in
surviving spouses estate under IRC Section 2036(a)(1) if he or she
is treated as a contributor/transferor of these assets,
particularly under Scenario #2 where separate shares for separate
property are not maintained IRS ruled favorably on this (no
inclusion) for JRT where general power of appointment was given to
first spouse to die [PLRs 200101021 and 200210051] 26
27. JRTs - Federal Income Tax Issues (Non-Community Property)
Amount includible in deceased spouses estate/amount generally
eligible for stepped-up basis, unless IRC Section 1014(e) applies
Can trustee pick and choose assets upon division at the first
spouses death, or does fractional interest of each asset have to be
used? Other reporting issues common to joint spousal accounts Only
one spouses SSN can be used during joint lifetime Separate EIN must
be obtained for deceased spouses portion of trust at first spouses
death (administrative trust) and for bypass trust Surviving spouses
SSN should be used for remaining portion of trust assets 27
28. Limited IRS Rulings on JRTs (Non-Community Property) PLR
200101021 Facts JRT funded solely with TBE property Either spouse
had unilateral right to revoke; if exercised, an undivided 50%
interest in the trust property was returned to each spouse as
tenants in common First spouse to die had testamentary general
power of appointment over all of the trust assets; upon failure to
exercise, amount equal to remaining exemption amount passed to
Credit Shelter Trust, any excess amount passed outright to the
surviving spouse IRS ruled as follows: No completed gift upon
funding due to unilateral right to revoke Deceased spouses one-half
of the trust assets included in his/her estate under IRC Section
2038, surviving spouses one-half of trust assets included deceased
spouses estate under IRC Section 2041 Completed gift of surviving
spouses one-half of trust assets to deceased spouse at first
spouses death qualifies for the gift tax marital deduction and
prevents stepped-up basis in this portion under IRC Section 1014(e)
Credit Shelter Trust not includible in surviving spouses estate
because the property is treated as passing from the deceased spouse
and not from the surviving spouse 28
29. Limited IRS Rulings on JRTs (Non-Community Property) PLR
200210051 Facts JRT funded with JTWRS and/or separate property
Either spouse had unilateral right to revoke; if exercised, trust
property was to be distributed in accordance with the direction of
both spouses Each spouse also had a unilateral power to withdraw
principal (lifetime general power of appointment) Upon first
spouses death, trust was divided into Credit Shelter Trust (up to
deceased spouses remaining exemption amount) and Marital Trust IRS
ruled as follows: Portion of trust property transferred to the
trust by the deceased spouse was included in his/her estate under
IRC Section 2038, portion contributed by the surviving spouse
included in deceased spouses estate under IRC Section 2041
Completed gift of surviving spouses entire interest in the trust to
deceased spouse at first spouses death qualifies for the gift tax
marital deduction and prevents stepped-up basis in this portion
under IRC Section 1014(e) Credit Shelter Trust not includible in
surviving spouses estate because the property is treated as passing
from the deceased spouse and not from the surviving spouse 29
30. Other Post-Mortem Administrative Issues (Non-Community
Property) Can be cumbersome/confusing having one trust document for
deceased shares irrevocable portion and surviving spouses revocable
portion after first spouses death Consider transferring surviving
spouses portion into newly-created separate revocable trust 30
31. Community Property JRTs Statutes in AL and TN allow
nonresidents to establish a community property trust, and to
potentially convert property transferred to the trust to community
property At least one trustee must be a resident of the state See
Alaska Stat. 34.77.020 - 34.77.995; 4.Tenn. Code Ann. 35-17-101, et
seq. IRC Section 1014(b)(6) says the surviving spouses one-half
share of community property held under the community property laws
of any state shall be eligible for a stepped-up basis US Supreme
Court ruled that a statute allowing spouses to elect a community
property system under Oklahoma law would not be recognized for
federal income tax reporting purposes. [Commissioner v. Harmon, 323
U.S. 44 (1944)] The Harmon decision should also apply to the Alaska
system for income reporting purposes. [Internal Revenue Manual,
Section 25.18.1.1.2] Case was decided prior to the allowance of
joint returns IRS argued income should be included on husbands
separate return under the assignment of income doctrine Rev. Rul.
77-359 - Washington couple agreed to convert their separate
property to community property. IRS ruled that conversion was
effective for federal tax purposes, but added To the extent that
the agreement affects the income from separate property and not the
separate property itself, the Service will not permit the spouses
to split that income for Federal income tax purposes where they
file separate income tax returns. See Blattmachr, Zaritsky and
Ascher, Tax Planning with Consensual Community Property: Alaskas
New Community Property Law, 33 Real Property, Probate and Trust
Journal (Winter 1999). 31
32. Contact Information Brian P. Tsu Partner Henderson Caverly
Pum & Charney LLP 12750 High Bluff Drive, Suite 300 San Diego,
CA 92130 Tel: (858) 755-3000, Ex. 130 Fax: (858) 755-9900 E-mail:
[email protected] Melinda Merk, JD, LLM, CFP Senior Vice President,
Regional Trust Advisor Private Wealth Management SunTrust Bank 8330
Boone Blvd, Suite 700 Vienna, VA 22182 Tel: 703/442-1534 Fax:
703/859-7653 [email protected] 32
33. Bios Brian Tsu is a partner in the Estate Planning,
International Private Client and Taxation Groups at Henderson,
Caverly, Pum & Charney LLP. Mr. Tsu advises clients in the
areas of domestic and international estate planning, business
succession planning, estate and trust administration and charitable
planning. Mr. Tsu also advises clients on a variety of domestic and
international tax matters, including federal wealth transfer,
fiduciary income and business entity taxation. Mr. Tsu received his
LL.M. in Taxation in 2009, from Northwestern University School of
Law, received his law degree in 2004, from the University of Dayton
School of Law, received his Master of Science in Professional
Accounting in 2002, from Seton Hall University and his bachelors
degree in Accounting in 2000, from Boston College. Mr. Tsu is
admitted to practice law in California and Illinois and is also a
registered certified public accountant (Illinois). Mr. Tsu is a
regular speaker and contributing member of the American Bar
Association, Tax and Real Property, Trust & Estate Sections;
the Society of Trust and Estate Practitioners (STEP); the
California State Bar Association, Taxation and Trusts & Estate
Sections; the San Diego County Bar Association, Estate Planning,
Trust & Probate Section. 33
34. Bios Melinda Merk is a Senior Vice President and Regional
Trust Advisor and part of the Greater Washington Private Wealth
Management team at SunTrust Bank. She focuses on providing multi-
generational wealth transfer planning advice and estate and trust
services to high net worth individuals, families , and business
owners. Melinda has over 18 years experience in the estates and
trusts area. Her prior experience includes serving clients as a Tax
Director in the Personal Financial Services group at
PricewaterhouseCoopers LLP, and as a Tax Manager in the National
Tax Department at Ernst & Young LLP. She was also engaged in
the private practice of law as a Senior Counsel in the Private
Wealth Services group at Holland & Knight LLP. She has
significant experience advising clients with regard to domestic and
foreign trusts, family limited partnerships, grantor retained
annuity trusts, dynasty trusts and other wealth transfer
strategies, charitable trusts, estate and trust administration, and
asset protection planning. Melinda received a B.S. (cum laude) from
Shepherd College, a J.D. from the Duquesne University School of
Law, and an LL.M. in Taxation (with distinction) from the
Georgetown University Law Center. She is also a Certified Financial
Planner. 34